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Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition by Aswath Damodaran

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CHAPTER 6

Market Efficiency—Definition, Tests, and Evidence

What is an efficient market? What does it imply for investment and valuation models? Clearly, market efficiency is a concept that is controversial and attracts strong views, pro and con, partly because of differences between individuals about what it really means, and partly because whether markets are efficient or not is a core belief that in large part determines how an investor approaches investing. This chapter provides a definition of market efficiency, considers the implications of an efficient market for investors, and summarizes some of the basic approaches that are used to test investment schemes, thereby proving or disproving market efficiency. It also provides a summary of the voluminous research on whether markets are efficient.

MARKET EFFICIENCY AND INVESTMENT VALUATION

The question of whether markets are efficient, and, if not, where the inefficiencies lie, is central to investment valuation. If markets are in fact efficient, the market price provides the best estimate of value, and the process of valuation becomes one of justifying the market price. If markets are not efficient, the market price may deviate from the true value, and the process of valuation is directed toward obtaining a reasonable estimate of this value. Those who do valuation well, then, will be able to make higher returns than other investors because of their capacity to spot under- and overvalued firms. To make these higher returns, ...

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